Unit 2 (Ch. 3 - 5)

The Paradox of Value

• Which is more valuable: diamonds or water?
  • Diamonds have greater exchange value
  • Water has greater use value
• Why does something essential (water) cost so little, while something non-essential (diamonds) costs so much?

Utility

• Utility: the satisfaction or benefit a person receives from consumption

• Utility is:

  • Subjective
  • Context-dependent
  • Not directly observable

• Economists do note measure utility directly; we infer it from choices

Revealed Preferences

• Revealed preferences: choices reveal the ordering of preferences
  • If \(A \succ B\) and \(B \succ C\), then \(A \succ C\)
• Willingness to pay provides a practical way to approximate utility

Marginal Utility

• Marginal utility: the additional satisfaction from one more unit of a good

• Law of diminishing marginal utility: As consumption increases, marginal utility decreases

• Utility increases with consumption, but at a decreasing rate

• Because water is abundant, its marginal utility is low

• Because diamonds are scarce, their marginal utility is high

Marginal Utility

Demand

• If:
  • Utility \(\approx\) willingness to pay, and
  • Marginal utility falls with each additional unit consumed,
• Then:
  • Price and quantity demanded are negatively related
  • This is the Law of Demand

Why Does the Law of Demand Hold?

Three reinforcing forces:

• 1. Diminishing Marginal Utility
  • Each additional unit provides less additional satisfaction
• 2. Income Effect
  • When price rises, purchasing power falls
  • Like a pay cut: you can afford less overall
• 3. Substitution Effect
  • When a good becomes relatively more expensive, people shift toward alternatives
  • Example: if the price of coffee rises, some consumers switch to tea

The Consumer Decision Rule

Individuals continue consuming until:

\[ \text{Marginal Utility} = \text{Price} \]

• If price falls:
  • \(MU > P\)
  • Consume more until equality is restored
• If price rises:
  • \(MU < P\)
  • Consume less until equality is restored

Demand

Demand

Determinants of Demand

Determinants of Demand

A change in any of the following shifts the entire demand curve:

• Tastes and Preferences
  • If Crocs become more popular → demand increases
  • If they fall out of fashion → demand decreases
• Number of Buyers
  • Larger population → greater demand
  • Increase in the legal drinking age → fewer buyers → lower demand for alcohol

Determinants of Demand

A change in any of the following shifts the entire demand curve:

• Income
  • Normal goods: demand rises as income rises
  • Inferior goods: demand falls as income rises
• Prices of Related Goods
  • Complements: price of \(Y\) ↑ → demand for \(X\) ↓
    
  • Substitutes: price of \(Y\) ↑ → demand for \(X\) ↑

Determinants of Demand: Research Example

Bartsch (2026)

Determinants of Demand

A change in any of the following shifts the entire demand curve:

• Expectations
  • Expect higher future prices → greater demand today
  • Expect lower future prices → lower demand today

Determinants of Demand: Research Example

Chopra, Roth, and Wohlfart (2025)

Demand vs. Quantity Demanded

• Demand: the entire relationship between price and quantity

  \[ Q(P) = a - bP \]

• Quantity demanded: the specific quantity at a given price

  \[ Q(P_1) = a - bP_1 \]

• A change in price causes:

  • A movement along the demand curve
    
  • NOT a shift of the curve

Demand vs. Quantity demanded

Demand vs. Quantity demanded

Elasticity of Demand

• Price Elasticity of Demand: measures how responsive quantity demanded is to a change in price

• Visually:

  • Elastic demand → relatively flat curve
  • Inelastic demand → relatively steep curve

• Interpretation:

  • Elastic: a small change in price → large change in quantity
  • Inelastic: a large change in price → small change in quantity

Elasticity of Demand

What Affects Demand Elasticity?

• Elasticity tends to be greater when:
  • There are close substitutes
  • Consumers have weak brand attachment
  • The good is a luxury rather than a necessity
  • Consumers have more time to adjust
• Elasticity tends to be smaller when:
  • There are few substitutes
  • The good is a necessity
  • The good represents a small share of income

Elasticity of Demand: Research Example

Bernard et al. (2025)

Supply

• Supply reflects the minimum amount sellers are willing to accept to provide different quantities of a good or service
  • The supply curve represents all quantities sellers are willing to sell at each possible price
• The Law of Supply: There is a positive relationship between price and quantity supplied
  • A change in price causes a movement along the supply curve
  • A change in supply shifts the entire curve

Supply

Why do Supply curves slope upwards?

Supply vs. Quantity supplied

Determinants of Supply

A change in any of the following shifts the entire supply curve:

• Cost of Inputs
  • Increase in wages → supply decreases
  • Decrease in raw material costs → supply increases
• Productivity (Technology)
  • Improved production technology → supply increases
  • Better worker training → supply increases

Determinants of Supply

A change in any of the following shifts the entire supply curve:

• Number of Producers
  • Entry of new firms → supply increases
  • Firms exiting the market → supply decreases
• Expectations
  • Expect higher future prices → supply today decreases
  • Expect lower future prices → supply today increases

Elasticity of Supply

• Price Elasticity of Supply: Measures how responsive quantity supplied is to a change in price

• Visually:

  • Elastic supply → relatively flat curve
  • Inelastic supply → relatively steep curve

• Interpretation:

  • Elastic: a small change in price → large change in quantity supplied
  • Inelastic: a large change in price → small change in quantity supplied

What Affects Supply Elasticity?

The primary determinant is time.

• Short run:
  • Supply is more inelastic
  • Firms cannot easily adjust capital or capacity
• Long run:
  • Supply is more elastic
  • Firms can enter, exit, expand, or adopt new technology
• Other factors:
  • Availability of inputs
  • Flexibility of production processes

Equilibrium

• The Supply & Demand model is a partial equilibrium (PE) model

• It focuses on one market at a time

  • Captures the primary effects within that market
  • Does not track all ripple effects across the entire economy

Equilibrium

• Analogy:
  • Like observing the first wave from a stone thrown into a pond
  • PE models focus on the immediate impact
• A key assumption: ceteris paribus
  • “All else equal”
  • We hold other factors constant while analyzing one change

Market Equilibrium

• The interaction of supply and demand determines market price

• The equilibrium price is the price at which:

\[ Q_D = Q_S \]

• At this price (denoted as \(p^*\)):
  • Quantity demanded equals quantity supplied
  • There is no pressure for price to change

Market Equilibrium

It is called “equilibrium” because competitive forces eliminate imbalances

• If price is too high: \(Q_D < Q_S\) (surplus)
  • Sellers compete for customers
  • Price is pushed down
• If price is too low: \(Q_D > Q_S\) (shortage)
  • Buyers compete for goods
  • Price is pushed up

Equilibrium

Demand Increases

Demand Increases

• Consider the market for eggs at Easter:
  • \(\uparrow D_e\)
  • \(\uparrow P_e\) and \(\uparrow Q_e\)
• The higher price serves two key allocation purposes:
  • Encourages consumers to conserve (reduce quantity demanded)
  • Encourages producers to expand output
    • Prices coordinate behavior without central direction

Demand Decreases

Demand Decreases

• Consider the market for the Apple Macintosh Portable:
  • \(\downarrow D_{pc}\)
  • \(\downarrow P_{pc}\) and \(\downarrow Q_{pc}\)
• The lower price serves important allocation purposes:
  • Signals producers that the product is less desired
  • Frees scarce resources (labor, capital, materials) for more valued uses

Supply Decreases

Supply Decreases

• Consider the market for avocados after a drought:
  • \(\downarrow S_a\)
  • \(\uparrow P_a\) and \(\downarrow Q_a\)
• The higher price:
  • Encourages consumers to conserve
  • Encourages producers to increase production where possible
  • Rations the now-scarcer good without central direction

Supply Increases

Supply Increases

• Suppose zoning laws are relaxed, making it easier to build homes:
  • \(\uparrow S_h\)
  • \(\downarrow P_h\) and \(\uparrow Q_h\)
• The lower price:
  • Makes housing more affordable
  • Expands access
  • Encourages greater market activity

Supply Increases: A Common Misconception

• “Housing is more expensive where there are more homes. Therefore, building more homes makes housing more expensive.”
  • This confuses correlation with causation.
• Expensive cities have high demand.
  • Increasing supply puts downward pressure on prices.

Supply Increases: A Common Misconception

Supply Increases: A Common Misconception

Jevons Paradox

• Jevons Paradox: When technological improvements make a good or service cheaper or more efficient, total usage can increase — not decrease.

• Efficiency ↓ cost of use

  • Lower cost → higher quantity demanded
  • If demand expands enough, total usage rises

• Originally observed in coal:

  • More efficient steam engines
  • Lower effective cost of coal
  • Total coal consumption increased

Jevons Paradox

Jevons Paradox

• Example: ATMs and bank tellers
  • ATMs reduced routine transaction costs
  • Branches became cheaper to operate
  • Banks opened more branches
  • Tellers shifted toward customer service & advisory roles
• Why didn’t teller employment immediately fall?
  • Lower cost → expanded demand for banking services
  • Automation substituted for some tasks
  • But complemented higher-skill tasks

Induced Demand

• When expanding supply lowers the cost of use, quantity demanded increases — often offsetting the intended benefit.

• Transportation example:

  • Expanding highways ↓ travel time
  • Lower travel time = lower “price” of driving
  • More people choose to drive

• Empirical evidence: Goodwin (1996)

  • Short run elasticity ≈ −0.5
  • Long run elasticity ≈ −1.0
    • A 1% decrease in travel time → 1% increase in traffic in the long run

Induced Demand: Why This Happens

• Adding road capacity shifts supply right:
  • ↓ travel time
  • ↓ effective cost of driving
  • ↑ quantity demanded
• Over time:
  • People move farther from work
  • More discretionary trips occur
  • Development patterns adjust
• Result: Congestion returns.

Induced Demand: Research Example

Duranton and Turner (2011)

PE Predictions: Single Shift

PE Predictions: Double Shifts

PE Predictions: Double Shifts

Double Shifts: Research Example

Howard, Wang, and Zhang (2024)

The Role of Prices in Allocation

• Prices emerge from the voluntary interactions of buyers and sellers

• They allocate scarce resources:

  • Toward those who value them most
  • Toward producers who can supply them most efficiently

• No central authority decides:

  • How guacamole prices should adjust
  • Which firms process the remaining avocado supply
  • Which cities receive shipments
  • Which consumers ultimately recieve them

Prices as Information

• Efficient allocation requires a way to compare the value of alternative uses of resources
  • Most inputs can produce multiple outputs and most outputs can be produced using different inputs
  • Prices provide a common measure of value
• Without prices:
  • Allocation becomes arbitrary
  • Or dependent on subjective judgment
  • Or reliant on incomplete information

Markets as a Dynamic Process

• Markets are constantly evolving
  • A drought in one region can shift production elsewhere
  • A change in input costs can alter supply chains
  • Adjustment occurs fluidly — without central direction
• Each participant holds only a small piece of knowledge
  • Individuals act in their own interest
  • Not to serve society
  • But to exchange labor and skills for income
• Markets coordinate this dispersed knowledge

The Invisible Hand

Central Planning vs. Decentralized Markets

• After WWII, economists debated centralized vs. decentralized planning.
  • F.A. Hayek opposed the idea of a Central Pricing Board
• His key insight:
  • Knowledge is dispersed
  • No central authority can gather or process all relevant information

Central Planning vs. Decentralized Markets

• Market prices:
  • Continuously incorporate local knowledge
  • Adjust dynamically
  • Reflect changing conditions
• Decentralized systems align with the dispersed nature of information.

Hayek

Hayek (1945)

An Excellent Hayekian Meme

Disequilibrium

• So far, we have focused on the allocative benefits of free markets.

• A free market is an economic system in which prices are determined by voluntary exchange between buyers and sellers, without external restrictions.

• In reality, many markets operate under artificial price restrictions, such as:

  • Minimum wage laws
    
  • “Price gouging” laws
    
  • Rent control
    
  • Zoning regulations

Price Floors and Price Ceilings

• Governments sometimes regulate prices by making certain transactions illegal.
  • When binding, these policies prevent the market from reaching equilibrium.
• Price floor: a legal minimum price.
  • Example: minimum wage.
• Price ceiling: a legal maximum price.
  • Example: rent control.

Price Floors and Ceilings

Disequilibrium: Impacts of Price Controls

• Price controls generate both direct and indirect effects.
  • The overall impact depends on whether the price control is binding.
• Direct Effects
  • Shortages (with binding price ceilings)
  • Surpluses (with binding price floors)
• Indirect Effects
  • Changes in quality
  • Longer wait times
  • Substitution toward alternative goods
  • Emergence of black markets

Example: Direct Effects of Disequilibrium

Lordan and Neumark (2018)

Example: Direct Effects of Disequilibrium

Example: Direct Effects of Disequilibrium

Example: Direct Effects of Disequilibrium

Clemens, Edwards, and Meer (2025)

Example: Direct Effects of Disequilibrium

Burkhauser, McNichols, and Sabia (2025)

Example: Direct Effects of Disequilibrium

Sabia and Burkhauser (2010)

Where will MW be most binding?

Surplus (Welfare) and DWL

• Consumer Surplus = the difference between what consumers are willing to pay and what they actually pay.

• Producer Surplus = the difference between what producers receive and their minimum acceptable price.

• When price controls are binding:

  • Fewer goods are bought and sold.
  • Mutually beneficial trades are lost.
  • This lost welfare is known as deadweight loss (DWL).

Surplus (Welfare) and DWL

Practice: Disequilibrium

• What is the quantity demanded at P₂? Quantity supplied?
• Is there a shortage or surplus at this price? If so, how large is it?
• What is the consumer surplus?
• What is the producer surplus?
• What is the deadweight loss?

Practice: Disequilibrium

• What is the quantity demanded at P₁? Quantity supplied?
• Is there a shortage or surplus at this price? If so, how large is it?
• What is the consumer surplus?
• What is the producer surplus?
• What is the deadweight loss?
• Are consumers (producers) made better or worse off? By how much?

Practice: Disequilibrium

Indirect Effects of Price Controls: Adjustment

Indirect Effects of Price Controls: Adjustment

Indirect Effects of Price Controls: Quality Declines

• “[The results]… imply that rent-controlled housing has depreciated faster than other rental housing” (Randolph 1988)

• “Rent control results in]… the deterioration and removal of dwellings from the rental stock” (Murray et al. 1991)

• “In Manhattan, we found that there was almost a 9% higher probability of an older and smaller building being in unsound condition if its units were rent controlled versus uncontrolled” (Gyourko and Linneman 1990)

Indirect Effects of Price Controls: Black Markets

Indirect Effects of Price Controls: Black Markets

• When binding price controls create shortages, some exchanges move outside legal markets, replacing regulated transactions with informal or illegal ones.
  • Market activity is likely to persist, but under less transparent and often riskier conditions.
• Reduced legal protections for participants
  • Example: renters paying “under the table” may have limited recourse against unsafe housing conditions.
• Increased legal risk for suppliers
  • Example: Fines, penalties, or criminal charges for violating price regulations.

Indirect Effects of Price Controls: Black Markets

“Sex workers have historically faced harm from clients. However, sex workers have claimed that internet platforms, such as Craigslist erotic services (ERS), reduced that violence. Using the staggered rollout of ERS for identification, we find that it is likely that ERS reduced female homicides by between 12 and 18 percent and … [sexual assault] offenses by between 7 and 9 percent. We hypothesize that this was due to more transactions occurring indoors, better screening efforts, and more efficient matching. Our results suggest that some internet platforms may mitigate the historical risks sex workers have faced.” (Cunningham, DeAngelo, and Tripp 2024)

Disequilibrium

Summary